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What's all the fuss about "pass-through income"?

Tax reform analysis
How would GOP tax plan affect middle class Americans? 11:19

The GOP House proposal for the biggest overhaul in the US tax code in some 30 years has been out for barely a day, but already it's being dissected to find the winners and losers. One of the winners most analyses have pointed to are people who earn their money via so-called pass-through businesses, such as sole proprietorships, partnerships, limited liability companies (LLC) and S-corporations. 

Most business in the US are organized as one of these entities. According to the Brookings Institution, about 95 percent of businesses fall into that category. 

The Republicans' pro-business tax legislation includes a potentially valuable break for these business' and their owners. Here's what you need to know.

Income earned by a business organized as a pass-through entity must be distributed as taxable income to its owner, members or partners. The pass-through entity itself doesn't pay income taxes, but it also can't defer tax on profits to be used later to reinvest in the business. Instead, all of its income is distributed each year to the individuals who own the pass-through entity, and they must pay tax on the profits. 

Their tax rate is based on their personal income tax rates (currently ranging from 10 percent to 39.6 percent), Social Security and Medicare taxes (as high as 15.3 percent), the net investment income tax (3.8 percent on income over $200,000 as part of the Affordable Care Act) and unemployment taxes.

Without accounting for state income taxes, the combined top marginal rate for income earned by a pass-through business owner can be as high as 46.2 percent. According to an Overview of Pass-Through Business in the U.S. by the Tax Foundation, the majority of pass-through business income is taxed at the top individual tax rates.

House GOP unveils details of tax proposal 05:05

C-corporations, which differ from pass-throughs, are allowed several tax advantages, which include the ability to pay a lower tax rate on profits and even defer taxes on profits, which can then be used to reinvest into the business.

When distributed to shareholders, C-corp profits are subject to a corporate tax rate, ranging from 15 percent to 35 percent. The House tax plan includes cutting this maximum tax rate to 20 percent.  

To address the disparity between the taxation of income earned by pass-throughs and C-corps, the tax plan includes a new tax rate of 25 percent for "pass-through business income." This provision would allow pass-through businesses to characterize a portion of their income as "profit" and not "salary."

The 25 percent tax rate would apply only to the "profit income" that's distributed to the pass-through business owners. The "salary income" that's distributed would still be subject to personal income tax rates. To prevent people from abusing this lower tax rate (by declaring all their business income as profit and none as salary), the provision includes a few limits.

First, the income earned by professional services providers, such as doctors, lawyers, accountants and others wouldn't qualify for the lower tax rate.

Other business owners could choose one of two options to take advantage of the new lower rate on some of their income:

  • Categorize 70 percent of income as salary (subject to their individual tax rates) and 30 percent as business income (taxed at the 25 percent rate)
  • Set a ratio of their salary income to business income based on their level of capital investment.

Another tax benefit of characterizing some of the income distributed by a pass-through business as profit income is the additional savings of the self-employment tax on that portion of income. A tax savings would be created because you pay self-employment tax only on your salary income and not on business profit income.

Most small-business owners use the popular LLC entity. To take advantage of this new lower pass-through rate, the LLC owner must make an S-corp tax election by notifying the IRS. Then the LLC owner can distribute a portion of the business income as a reasonable salary and a portion can be retained and distributed at year-end as business income. 

Certain timelines govern when an S-corp tax election can be made. Also, when paying yourself a salary, you're required to file additional returns for payroll on a quarterly basis.

You should know that setting up an LLC entails additional costs and filings to maintain it each year. Those costs should be compared to the possible tax savings. Also know that this strategy can increase the risk getting audited by the IRS. As you might guess, you should consult a professional tax adviser to determine if an LLC is right for you.

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